Inference for volatility-type objects and implications for hedging

Mykland, P.A. and Zhang, L.


The paper studies inference for volatility type objects and its implications for the hedging of options. It considers the nonparametric estimation of volatilities and instantaneous covariations between diffusion type processes. This is then linked to options trading, where we show that our estimates can be used to trade options without reference to the specific model. The new options ``delta'' becomes an additive modification of the (implied volatility) Black-Scholes delta. The modification, in our example, is both substantial and statistically significant. In the inference problem, explicit expressions are found for asymptotic error distributions, and it is explained why one does not in this case encounter a bias-variance tradeoff, but rather a variance-variance tradeoff. Observation times can be irregular.

Keywords: volatility estimation, statistical uncertainty, small interval asymptotics, mixing convergence, option hedging

Heidi Sestrich 2003-10-15
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